October High Yield Credit Update

Monthly Commentary

The pendulum swung hard in October, at least within the context of recent episodes
of risk aversion, as high yield credit re-priced sharply with risk assets broadly –
the S&P 500 declined 6.8% on the month, front month WTI prices collapsed $11
from local highs, and high yield credit spreads widened ~80bps immediately after
setting fresh tights for this cycle on October 3rd. Unsteady fundamentals, or more
accurately, heightened investor alertness thereof (indeed, excessive corporate
leverage, notably in IG/BBB-rated credit, and optimistic growth expectations are
not new, just newly appreciated) helped spark the inflection in sentiment, while an
excess of macro developments (U.S.-China trade tensions, softening China growth,
Italy’s budget woes, oil price volatility to name a few) acted as an accelerant. As
complacency swung to fear and losses compounded, seemingly exaggerated (and
swift) downdrafts in prices of highly levered and over-bought investments surfaced
en masse. Specifically, the crowded trades among the hedge fund herd (both in credit
and equities, i.e. FAANG) in some cases saw prices gap 20pts+ lower as holders
collectively clamored for the exits, selling into a void:

Source: Bloomberg

Investor behavior has been conditioned in recent years to ‘buy the dip’ as such
a strategy has been rewarded consistently in the aftermath of recent incidents
of volatility. Interestingly, that learned behavior (or said another way, the paired
association between buying the dip and short-term gains) is currently on trial as the
reward of positive returns remains elusive, despite now two attempts by investors to
step in and buy. Time will tell whether this Pavlovian conditioning breaks down.

Two Failed Attempts to Find Support Thus Far
(Bloomberg Barclays U.S. HY Index Average OAS)

Source: Bloomberg

Market Performance

High yield bond spreads reached this cycle’s tights as well as this year’s wides (at least until November 14th) all in a single
month (and in that order chronologically). As such, the +80bps intra-month route drove negative returns of -1.60% for the asset
class in October, the worst monthly performance for high yield credit this year, erasing nearly 60% of year-to-date gains through
September. High yield returns remain modestly positive for the year through October at +0.93%, though as we write, resurfacing
downward volatility in November continues to chip away at these gains (total return through November 14th stood at +0.45%).

Escalating volatility in risk assets during the month resulted in a decompression in risk premiums across several coherts – high
credit quality versus low credit quality, cyclical versus non-cyclical sectors, discrete crowded trades versus the rest of the market.
With respect to credit quality specifically, on a total return basis, higher quality lower risk investments outperformed. BB-rated credits
lost -1.37% in October, compared to the overall market and CCC-rated risk returning -1.60% and -2.46%, respectively. Despite the
decompression, CCCs are still outperforming BBs by 426 basis points this year, though with risk aversion mounting, fundamentals
underwhelming and sponsorship for high risk investments (one after the other) waning, a further unwind seems probable.

Source: Bloomberg, Barclays

Big moves in big capital structures resulted in big divergences in sector performance in October. While virtually every sector
posted negative returns for the month (save for Supermarkets with a modest +0.33% gain), those which housed last month’s
litany of landmines significantly underperformed. High beta energy credits specifically felt the one-two-three punch of falling
oil prices, deteriorating fundamentals and broad based hedge fund capitulation. Sanchez Energy, Weatherford International,
McDermott Technology, and Parker Drilling each saw the market prices of their bonds cut by 15-25pts during the month with the
pain extending into November.

Source: Bloomberg, Barclays

Capital fled the high yield marketplace in decent size in October following several months of relative stability. This contributed
to what has been a year (plus) of negative fund flows despite the positive trend of recent months. Near $6bn was redeemed
by investors from a combination of ETFs (~$3.7bn) and mutual funds (~$2.3bn) during the month. The outflows occurred
predominantly during the second week of October as the sell-off accelerated. Year-to-date, high yield bond funds have sustained a
net lost $31bn in assets (~$41bn including Q4’17), though with credit spreads oscillating within a tight band all year, and default
rates holding near cyclical lows, it is difficult to argue the exodus has proven disruptive to asset prices (at least not yet).

Outflows Re-Emerged in October Concurrent with (Fueling) Market Volatility

Source: Credit Suisse, EPFR

With just four weeks remaining in the 2018 primary calendar, the book has effectively closed on new issuance for the year.
Wavering risk appetite in October brought little relief to the dearth of primary activity that has been a recurring feature of the
marketplace this year. Just $12bn in USD-denominated debt priced in October, the lowest volume for the calendar month since
the emerging oil and gas default cycle stressed capital markets activity in October 2015. The $165bn of new issuance year-to-date is down approximately 30% compared to 2017 and represents the lowest level of activity since capital markets shuttered amid
the financial crisis in 2009. While it is not unusual to see primary issuance turn off during discrete periods of market turbulence
(compounded by blackout windows during the October reporting season), certain emerging conditions may prove more structural
in nature. Of note, the rising all-in cost of capital due to higher interest rates (and prospectively wider credit spreads) is beginning
to push yields well above coupons, reducing the impetus for opportunistic refinancings. Said another way, the call option sold to
issuers in most high yield bonds is increasingly moving out of the money. This, along with continued cannibalization from the
leveraged loan market with respect to LBO/M&A financings, may lead to an extension of the supply drought into 2019.

Refinancings are Becoming Less Attractive as Yields Migrate Above Coupons…

Source: Credit Suisse

…And Sponsors are Again Favoring Loans Over Bonds for Financing Needs (Déjà Vu)

Source: Credit Suisse

Fundamental Trends

Following a protracted lull in corporate defaults from April through September, this past month saw a (modest) pick-up in
distressed activity. Troubled retailer Sears Holdings finally filed for bankruptcy in October, the second largest Chapter 11 filing this
year (behind iHeart). High yield bond issuers Jupiter Resources (an E&P company) and David’s Bridal missed interest payments
during the month, cross defaulting on just over $1bn and $750mn of debt, respectively. All considered, four companies, bond
and loan issuers, defaulted on $4.9bn of debt this past month, though the trailing 12-month default rate was virtually unchanged
at 2.0% (1.3% excluding iHeart). Though still early in the recent sell-off, the past month and a half of volatility is beginning to
stress a growing cohort of credits, which are dependent on significant earnings growth and/or accommodative funding markets
in order to sustain their balance sheets. One need look no further than Oil Field Services bellwether Weatherford International
to appreciate the precarious position in which several highly levered, cyclical credits find themselves. Time will tell whether this
month’s volatile capital structures are next month’s defaults.

Weatherford Unsecured Bonds Which Traded Near Par Sold Off >30Pts Since October 1st
with the Stock is Down -70% Over the Same Period